VALUATION ISSUES RELATING TO BUSINESS...
Transcript of VALUATION ISSUES RELATING TO BUSINESS...
VALUATION ISSUES RELATING TO BUSINESS ASSETS
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I. INTRODUCTION 1
II. METHODS OF VALUATION 5
A. AN ASSET VALUE APPROACH 7
B. THE INVESTMENT VALUE APPROACH 11
l. CAPITALIZATION OF EARNINGS 11
2. CASH FLOW ANALYSIS 17
( a) CASH FLOW CAPITALIZATION 19
( b) DISCOUNTED CASH FLOW ANALYSIS 21
C. COMBINED ASSET AND INVESTMENT VALUE APPROACH 22
III. MINORITY DISCOUNT/MAJORITY PREMIUMS 25
IV. ISSUES RELATING TO TAXATION 28
V. SUMMARY 30
VALUATION OF INTANGIBLES
(Goodwill-Particularly As It Relates toProfessional Practices)
Follows
ISSUES RELATING TO THE VALUATION OF BUSINESS ASSETS
I . INTRODUCTION
Portions of this paper were originally prepared for presentation at the
Shareholders Agreements Seminar, 1987 conducted by Continuing Legal
Education in the fall of last year. As was pointed out at that time
valuation is becoming increasingly important in several areas of the law
including circumstances entailing dissenting shareholder rights under the
various corporation acts and the increasing resort of shareholders to the
oppression of minority shareholder remedies under current corporate
legislation. Both these areas and current matrimonial legislation rely
heavily on the ability of a court to determine the proper value of business
assets. In recent years and notwithstanding the valuation itself is
effected by other professionals, it has become increasingly important in
order to protect the rights and interests of our clients that the legal
profession have an awareness of the valuation process, the underlying
assumptions and financial principles relied upon in valuation, and, the
various issues relating to such process generally.
One should bear in mind that the valuation process, however occasioned,
whether as a result of a marital dispute or a corporate reorganization,
involves essentially similar considerations, and, with few exceptions, the
prognostications which appear in the jurisprudence relating to one area
have or will have relevance ultimately for the others.
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However there are differences particularly in the latitude imported by the
applicable statutes to judicial determinations respecting value. Most
statutes governing corporations in Canada provide that a determination must
be made as to "a fair value" of shares whereas The Matrimonial Property Act
requires that the value to be determined is the "fair market value" of the
particular business property. Only if a fair market value cannot be
determined is the court entitled to import a reasonable value for the
property in question.
Primary as a result of its frequent occurrence in taxing statutes, the term
"fair market value" has been the subject of some considerable judicial
consideration including on several occasions in the Supreme Court of
Canada. On the basis of such decisions a reasonable working definition
would be an exchange value being that sum of money or monies worth which
could be obtained upon the sale of property between a vendor and buyer
dealing at arm's length, where neither the vendor nor the buyer are acting
under any compulsion to buy or to sell. The adjective fair modifies the
term market rather than the term value, and indicates a consistent market
free of transient boom or sudden panic (Untermyer v. The Attorney General
of British Columbia [1929] S.C.R. 84, Montreal Island Power Co. v. Laval
[1935] S.C.R. 304, Attorney General of Alberta v. Royal Trust Co. [1945]
S.C.R. 267, Smith and Rudd v. The Minister of National Revenue [1950]
S.C.R. 602). Where there is neither in fact a market or where the market
is not a competitive market as of the date of determination of value fair
market value must be determined from other indicia of value (Re Mann
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Estate, [1972].5 W.W.R. 23, Re Adam, 1979-80, 5 E.T.R. 223 and the
foregoing referred to decisions). In the case of business assets it is the
revenue producing capacity of the asset that constitutes these other
indicia and are the subject of analysis under the methods outlined in this
paper.
The distinction between fair value and fair market value can be significant
particularly as it relates to minority holdings in a business enterprise
and whether or not a minority discount is to be applied to such holdings
(for the definition of minority discount see the portion of this paper
entitled MINORITY DISCOUNTS/MAJORITY PREMIUMS). Under the jurisprudence
involving corporate statutes, as a result of the use of the term fair value
rather than fair market value there is certain flexibility permitted a
court in determining whether to apply or not to apply a minority discount
or to add a premium to price in the determination of value. It is unlikely
that this degree of flexibility is present or can be imported into a
statute which requires a determination of fair market value. One submits
that the flexibility of our courts in matrimonial circumstances to employ
concepts of equity, fairness and reasonableness in valuing assets relates
primarily to an ability to, first, select an appropriate date for valuation
being either the date of the application or the date of the adjudication
between the parties, and, secondly, to attribute a reasonable value where a
fair market value cannot be determined.
In regard to the former circumstance the decisions of the Saskatchewan
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Court of Appeal in Shockey v. Shockey (1983), 22 Sask. R. 106, Tataryn v.
Tataryn [1984] 3 W.W.R. 97, and, Carlson v. Carlson (1984), 34 Sask. R. 297
make clear that the choice of differing valuation dates for different
assets is to be avoided and only resorted to with adequate justification
and with written explanation. In regard to the latter circumstance (the
attribution of a reasonable value where a fair market value cannot be
determined) one submits that, absent a failure to adduce evidence as to the
revenue and profit capacity of a property, it would be unusual to have
circumstances which would permit resort to a reasonable value of
determination in respect of business assets.
It is therefore of particular importance to practitioners in the
matrimonial property area to have an adequate appreciation of the
traditional methods of valuation.
This paper will focus and frame its discussion in the context of an
evaluation of one of the most difficult assets requiring valuation: the
privately held, non-traded, corporation. However, the principles and
considerations reviewed here are with minor modifications equally
applicable to what one might term participating interests in many forms of
business organization such as partnership interests, units in a trust
carrying on business, or, proprietorships. A valuation of a corporation
involves, among other things, a valuation of the assets of that entity: the
application of such methods to a business or an apartment block owned by a
spouse will become self-evident.
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II. METHODS OF VALUATION
As opposed to other categories of assets, most business assets are
primarily the subject of acquisition and retention as a result of
prospective capital appreciation and/or the income or cash revenues that
the asset is capable of generating.
Many non-business assets such as one's house, cottage at the lake and cars
are frequently acquired for their value in use to the owner rather than
with a view to prospective monetary gain. It is also arguable that certain
business assets such as farm land are acquired on slightly different
considerations as they traditionally and consistently trade at values in
excess of their productive capacity. In this case it is equally arguable
that as a result of such consistency in the general appreciation in farm
land values over the long term (as opposed to the last few years) that
security in terms of capital appreciation is a principal consideration
although the preservation of a land base for successive generations is
likely also very important. From the writer's perspective I feel fortunate
that farm land is the subject matter of another paper at this seminar.
Yhere an asset is publicly traded such as the shares of a listed company,
the valuator's work has been done by the action of the public exchange.
Theoretically, cash flows and income after tax of a corporation has been
estimated and discounted or capitalized, as the case may be, minority
) discounts have been applied, share characteristics have been reviewed as to
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their effect on value, and this calculation and process reflected in the
published price of the share. In reality of course many publicly listed
shares are sold and acquired by persons who are inordinantly affected by
general trends, whether bearish or bullish, who lack the analytical tools
to properly evaluate the stock and who have limited information on the true
circumstance affecting a company, its assets and business. However, over
the longer term one can assume that share prices will be forced to reflect
underlying fundamentals.
It is axiomatic that the value of a share in a company is primarily
reflective of the business and assets of that company. When a share is not
publicly traded there are three primary methods of valuing the underlying
business:
A. an asset value approach,
B. an investment value approach represented by a capitalization of
earnings and/or a cash flow analysis, or
C. some combination of the foregoing methods.
Often one approach will have greater application than another to a
particular business enterprise as a result of the specific circumstances or
the particular characteristics of that business enterprise.
In addition, the value of any particular share or shareholdings will be
affected by the share's preferences and characteristics as established by
the articles of the corporation, whether the aggregate shareholdings being
valued represent a minority or majority interest in the corporation, and,
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the terms of any shareholders agreements in effect which restrict or extend
the rights of the shareholder beyond that which would normally be an
adjunct of the shareholding itself.
A. AN ASSET VALUE APPROACH
An asset value approach is most relevant:
(a) when there is concern about the validity of assessing the
corporation's value as a going concern; and/or
(b) where the rate of return (earnings) of the company, either
historically or temporarily, does not justify the continued
dedication of the company's assets currently employed in the
business or businesses of the company; and/or
(c) in certain types of companies such as holding companies or
investment companies where a significant portion of a company's
prospective value can be assumed to be related to appreciation in
its assets rather than reflected in current earnings.
Used in combination with the investment value approach, a liquidation
value, the principal method of asset valuation, is of worth in calculating
the degree of absolute risk where the investment earnings approach
indicates a value in excess of that determined by the assets.
Often the starting point to effect an asset valuation of a corporation is
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its financial statements. It should be clearly understood that undue
reliance on such statements will result in an unrealistic picture of, and
usually an understatement of, asset worth. It would be a miracle of
coincidence if the true asset value of a corporation equalled its book
value. Primarily this discrepancy arises as a result of the presentation
principles adopted by our friends the accountants for financial statement
preparation. Some of the rules that account for this discrepancy are as
follows:
(a) assets are shown on the financial statements at historical cost
subject to, where applicable, provision for depreciation and
amortization of that historical cost. The cost at which a company
acquired an asset or such cost net of depreciation may have little
or even no relation to the price which such asset might command if
disposed of in an open market;
(b) intangible assets, if shown on the company's books, will reflect
historical cost rather than current value. Many intangibles,
particularly those internally developed and financed, may not be
recorded at all or if recorded may be shown at a nominal cost even
though they may be of great value if disposed of in an open
market;
(c) investments in other entities or loans to other companies are
recorded only as to the quantum of the individual investment or
loan often in private companies, which do not have audits
performed, without consideration as to current value or
collectibility;
(d) the policy adopted on the financial statements to address the
degree to which accounts receivable are realizable may, due to
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income tax considerations, be overly conservative;
(e) the method adopted for recording inventory may not accurately
reflect obsolescence of such inventory or disposition by means
other than in the ordinary course of business;
(f) policies respecting the timing of recognition of income for
ongoing contracts can materially affect value;
(g) many contingent liabilities are not recorded in the statements;
(h) the acquisition of assets by the company utilizing the rollover
provisions of the Income Tax Act (Canada) can result in such
assets being shown at a cost far below actual market value.
In addition to the foregoing problems inherent in properly prepared
financial statements, the accounting profession provides us on the face of
the statements with a unique account termed the deferred tax account. This
account which is wholly notional is an attempt to reflect timing
differences between depreciation and its sister for tax purposes, capital
cost allowance. To the extent that capital cost allowance exceeds
depreciation on a cumulative basis, a disposition of those assets will
attract more taxable income than the statements would reflect as accounting
income and a greater tax liability would accrue to the company than would
be otherwise indicated on the face of its financial statements. This
account attempts to reconcile these differences to minimize the
misrepresentation inherent in the statements of the company's tax position
on a hypothetical disposition of assets at a hypothetical price (the
depreciated value of assets for statement purposes) usually at historical
) (but at best current) tax rates. This account reflects a prospective
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liability which is contingent upon events which are by no means certain to
occur or if they occur, are predicated on proceeds of disposition which may
not bear any relation to what would be the actual proceeds and all the
while assuming rates of taxation which are accurate more in an historical
context than either those currently in force or those which will be in
effect when and if such a sale occurs in the future.
The most appropriate measure for an asset approach to valuation is the
establishment of a liquidation value. Simply put, this approach involves a
determination of the aggregate value of the assets, if immediately disposed
of, less (a) aggregate liabilities, (b) the costs of disposition, (c) costs
related to cessation of business and (d) the taxes estimated to be exigible
thereon (net of taxes of a refundable nature). This approach also requires
a reduction be made in respect of taxes which would be payable by
shareholders on a distribution of the remaining assets, although the
retention of assets and reinvestment by the company will defer, perhaps
indefinitely, taxes on such a distribution. Any liquidation value requires
that a value is to be obtained for not only tangible but also the
intangible assets of the company, particularly if patents, trademarks or
other proprietary intangibles are material to the corporation.
Generally one would assume, in a manner consistent with the definition of
fair market value, that the assets would be disposed of in an orderly
rather than on a forced disposition/quick sale basis.
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B. THE INVESTMENT VALUE APPROACH
The investment value approach utilizes two methods of analysis or some
combination thereof:
1. capitalization of earnings; and/or
2. cash flow analysis (cash flow capitalization or a discount of
future cash flows).
Both methods of analysis utilize, albeit in different fashions, the
application of what can be termed for simplicity sake a "desired" rate of
return against projected corporate financial performance.
The investment value approach is only valid when one can safely assume that
the business in question is at present and is likely to remain into the
foreseeable future a going concern. This assumption is obviously heroic
if a reasonable possibility exists that the division of matrimonial assets
amongst the spouses will jeopardize the continued existence of the business
of the company.
1. Capitalization of Earnings
The most commonly employed method of analysis in a going concern situation
involves the capitalization of after tax earnings. After tax earnings,
after normalization, are multiplied by a capitalization multiple. The
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capitalization multiple is derived from a subjectively determined
capitalization rate or a required rate of return for a particular company
in a particular industry. To the derived value one then adds an adjustment
for what is termed redundant assets net of applicable income taxes.
The two variables that have to be determined for employment of this method
are first normalized after tax earnings and secondly the capitalization or
required rate of return. The capitalization multiple is mathematically
determined on the basis of the latter.
For example consider a business with normalized after tax earnings of
$100,000 a year in an industry where the required rate of return is 10% per
annum. Ignoring for the moment the issue of redundant assets, the value of
the business employing this approach would be the value of the earnings
flow, en bloc, of $100,000 per annum times a capitalization multiple which
reflects the desired rate of return. The capitalization multiple is the
inverse of the rate of return, in this particular example the inverse of
10% (1 ~ .1). This gives us a capitalization multiple of 10 and the value
of this business en bloc is therefore 10 x $100,000 ($1,000,000).
On the other hand if the required rate of return is 15% per annum, the en
bloc value of the company equals $666,667 ($100,000 x 1 ~ .15). A required
rate of return of 20.0% per annum results in this circumstance in an en
bloc value of $500,000.
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Please keep in mind that the above example is predicated on a company with
no redundant assets. We will touch upon this concept at the end of this
section.
As one can see from the above illustrations the ultimate value is extremely
sensitive to the selection of a required rate of return. The selection
process of an appropriate required rate of return is very subjective and is
one of the prinicpal contributions to the analysis of an experienced
valuator. The required rate of return or capitalization rate for purposes
of this approach is determined by reference to both internal and external
factors, the latter being factors beyond the company's control.
If a person could earn 9% by investing his money in long term Government of
Canada bonds (a "virtually" risk free investment) he will obviously desire
to realize a better rate of return from investment in the shares of a
company which are less than risk free. The amount by which the required
rate exceeds the risk free rate will depend on several factors.
If general economic conditions (e.g. employment, inflation, commodity
prices) are perceived as relatively stable lower capitalization rates and
thus higher multiples can be anticipated than if these factors are less
stable or if movements are anticipated to be adverse. If interest rates
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are expected to be stable or to tend downward, lower capitalization rates
can likewise be expected to be acceptable. The political environment for
the industry in which the company operates in Canada and the market to
which it sells will have an impact, particularly if the market is
international. The degree of competitiveness currently in the company's
industry as well as the nature of such competition and ease of entry will
affect the rate. Other factors include stability and availability of
sources and supply of inputs, materials and labour, the degree of
technological change being experienced or anticipated to be experienced for
the industry, and growth potential of prospective markets.
Numerous internal factors are also relevant in determining the appropriate
capitalization rate. Management dependence on the continued involvement of
personnel not easily replaced for various reasons increases risk and
therefore the capitalization rate. A significant degree of proprietary
protection (patents and other intellectual property) can be expected to
lower the rate. Up to date and well maintained fixed assets with little
likelihood of technological obsolescence in the near term can lower the
rate as can a stable and available labour force or the existence of long
term commitments in either or both of the supply and market sides of the
business. Lastly the degree of leverage or debt load carried by the
company also has an impact: a higher debt to equity ratio obviously
increases risk and thus the capitalization rate. A business which has
indicated in the past sustained growth and improved earnings will command a
lower capitalization rate.
(iii)
(iv)
(v)
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Secondly, the capitalization of earnings approach requires a derivation of
normalized after tax earnings. The analyst wants to ascertain what can be
viewed as the corporation's regular and sustainable flow of earnings over
the longer term, after tax. There are a number of other areas to which
attention must be paid so that normalized earnings may be arrived at, a few
of which include the following:
(i) extraordinary and non-recurring income items that would distort
the estimate of future profits such as a large capital gain on a
redundant asset;
(ii) non-arm's length expenses which are of an uneconomic nature such
as higher than market place wages paid to managing shareholders.
These payments reflect a form of additional return on investment
whereas insufficient salaries indicate an overstatement of
earnings;
consistency with the operating conditions expected to prevail;
additions to, or reductions in the capital of the company;
changes in rates of taxation over the period the historical after
tax earnings are generated; and
(vi) adjustments for earnings attributable to redundant assets.
In private and closely held companies it is more usual than unusual to see
salaries payable to directors, officers and employees which deviate
significantly from what such positions and duties would attract as salary
and other remuneration in an arm's length situation. Thus a material
adjustment to determine normalized earnings often involves accounting for
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such deviations.
Redundant assets in a company are assets which are not necessary or
required for the continued operation of a particular business. Sometimes
redundant assets are clearly discernible in respect of any particular
company such as term deposits, security portfolios, investments in other
businesses and the like. However, often the redundancy of assets can only
be determined after some analysis of the financial statements as well as
the specific business operations of the company. For example redundancy
would occur where extremely valuable real estate is retained by the company
for its operations when less choice premises would be equally suitable. A
company may be underleveraged in that its normal debt load could be less
than industry averages and less than what they could carry without any
unreasonable increase in risk. Alternatively an excess carriage of debt
may indicate negative redundancy in that for a business in this industry
additional capital injections may be required to reduce risk to an
acceptable level.
The effect that the existence of redundant assets can have on the valuation
of a business is easily illustrated. Assume for a moment that after tax
earnings normalized in all respects are $100,000 per year and that the
required rate of return is 12.5% per annum. As indicated previously the en
bloc value of this company would be $800,000. However, the company has
$200,000 in term deposits which are clearly not necessary for its
operation. The historical rate of return on the term deposits has been 5%
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after tax ($10,000). Normalization of earnings for these redundant assets
would indicate annual after tax earnings of $90,000 and thus given the
required rate of return of 12.5% per annum a value of $720,000 to which
value one has to add the value of the redundant asset being $200,000 less
tax exigible on distribution (say 40%). The true value therefore of the
subject company would be $840,000 which is in excess of the originally
determined $800,000. The realization that redundant assets exist in a
company can radically affect an ultimate determination of value.
We have seen a clear indication in recent years in Saskatoon of an example
of redundant assets. Ten to fifteen years ago many automobile dealerships
were situate in downtown Saskatoon or at least centrally located. In the
intervening years most of these companies have moved their operations to
industrial and outlying areas of the city replacing their former lands and
facilities at a fraction of the proceeds realized on the sale of the
lands (often constituting substantial holdings) formerly owned by them.
Cases substantially similar to this can be found in many companies.
2. Cash Flow Analysis
Rather than focusing on the after tax earnings of a corporation this
approach concentrates attention on the ability of a corporation and its
business to generate positive cash flows either by capitalizing cash flows
much in the same manner that after tax earnings are capitalized, or, by
) discounting future cash flows. While not generally as well known as other
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methods discount analysis is often employed in valuation situations.
As with the earnings approach to valuation, cash flow and discount analysis
assumes that the business entity will continue to operate as a going
concern and implicit in this premise is an assumption of an indefinite
life.
Cash flow and discount analysis, while somewhat more complex than the,capitalized earnings approach, has certain advantages in that it recognizes
that capital cost allowance (depreciation for tax purposes) is most often
taken on a declining balance basis thus providing a greater shelter in
respect of taxation in earlier than later years. In addition accelerated
write-off assets which are permitted pursuant to the tax legislation to be
written off very quickly and far in advance of the expiration of their
useful life can be more adequately given credit under a discount analysis
than pursuant to other approaches. Lastly there are no problems or issues
arising in respect of notional accounts such as the deferred tax account
which need arise with an analysis of cash flow whereas they can impact on
other forms of valuation.
Cash flow or discount analysis can often provide a truer report to a
prospective purchaser as to an actual rate of return since the analysis
requires a determination of what funds generated by the business are
actually returnable to an investor without jeopardizing the continued
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existence of that business. While this is generally the case also with the
capitalization of after tax earnings approach there are situations where
after tax earnings can be in excess of what is actually returnable by way
of dividend to a shareholder. This generally arises as a result of
continuing capital requirements of the business exceeding the depreciation
accounts maintained by the business on its books.
(a) Cash Flow Capitalization
Cash flow capitalization applies the appropriate capitalization rate (see
prior discussion under the after tax earnings approach) to what one might
term the discretionary cash flow generated from operations taken on an
after tax basis. To this capitalized value is added redundant assets (net
of applicable income tax) together with the discounted present value of the
future tax savings implicit in the undepreciated capital cost of
depreciable property.
The discretionary cash flow generated by operations after tax constitutes
only a portion of the actual cash flow from such operations. A portion of
the cash flow generated from operations has to be expended and reinvested
in operations so as to sustain them at current levels. These
non-discretionary cash flows required for reinvestment are used to repair,
maintain and replace current plant and equipment so as to maintain the
current competitive position of the company in the industry in which it
) operates. It is clear that technological change will impact significantly
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upon the level of reinvestment required. Generally however capital
reinvestment requirements and outlays are estimated by reference to
historical capital expenditures to the extent that they are not used to
increase capacity, by assessing the efficacy of the application of those
maintenance type capital expenditures in maintaining current plant and
equipment both in respect of its condition and in respect of its
technology. The foregoing analysis of cash flows generally and
non-discretionary cash flow requirements provide a determination of
discretionary cash flow generated from operations.
We have previously discussed the required analysis to determine redundant
assets. The shelter addition as a result of subsisting undepreciated
capital cost in the company is determined by a formula as follows:
Undepreciated Capital Cost x Income Tax Rate x Capital Cost Allowance Rate
Capitalization Rate + Rate of Capital Cost Allowance
The foregoing formula is the determines the present value of future
prospective tax savings related to the existence of undepreciated capital
cost in a company. The chief indeterminant variable in the formula relates
to the income tax rate which is presumed to be fixed over prospective years
but in fact may vary substantially.
A simple example of application of the above formula would be as follows:
Aggregate Undepreciated Capital Cost: $400,000
Income Tax Rate: 50%
Capital Cost Allowance Rate: assume weighted average rate of 20%
Capitalization Rate: 15%
400,000 x .50 x .20
.15 + .20
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$114,286
In summary if one adds to net income before tax all non-cash charges such
as depreciation and amortization and subtracts from such aggregate amount
taxes based upon such amount you get a determination of after tax net cash
flow. From after tax cash flow is to be deducted the required sustaining
capital reinvestment requirements of the business (less the present value
of the shelter provided by current undepreciated capital cost). This
determines the cash flow after tax to which is applied the capitalization
rate.
(b) Discounted Cash Flow Analysis
I propose to deal somewhat summarily with discounted cash flow analysis.
This approach involves projections in respect of prospective earnings and
future cash flows. The focus in a capitalization of earnings approach is
usually upon current or historical results rather than reliance upon
explicit prospective analysis as is the case with the discounted cash flow
analysis, notwithstanding that implicit in any analysis that presumes that
one is dealing with a going concern is the assumption that to some degree
current financial performance and historical financial performance will be
maintained prospectively.
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The discounted cash flow approach determines value by determining the
present value of future cash flow expectations.
Future cash flow expectations involve after tax profits plus non-cash
expenditures all as reduced by the level of sustaining capital reinvestment
requirements. Redundant assets are assumed to be realized at the
commencement of the period on which the analysis is predicated and either
the analysis projects cash flows into infinity or determines a residual
value of the business at the end of the analysis period. Discounted cash
flow analysis is particularly relevant when valuing businesses engaged
primarily in non-renewable resources such as oil and gas.
C. COMBINED ASSET AND INVESTMENT VALUE APPROACH
Invariably when a professional valuation is undertaken both an investment
approach analysis is effected together with a determination of the
liquidation value of the business. Absent special circumstances it is
common to utilize a value approaching the greater of the values determined
under each approach.
If the investment analysis generates a value in excess of liquidation
value, the difference between the two is a good indicator of the degree of
absolute risk inherent in the purchase.
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On the other hand if liquidation value is the greater value and an
appropriate discount has been applied to reflect the period of time
reasonably required to liquidate assets on an orderly basis, the purchaser
is always in a position where he can liquidate, repossess the resulting
cash proceeds and invest such proceeds virtually risk free.
The foregoing statements regarding acquisition at the higher of the
liquidation value or the going concern value are in practise not so
mechanically applied. It is clear that a purchaser looking at two
businesses both valued on an investment valuation approach at $800,000
would review his valuations and would be significantly influenced if the
first had a liquidation value of $600,000 and the second a liquidation
value of $400,000. His absolute risk in respect of the second enterprise
is significantly greater than the first. If the increase in absolute risk
is not clearly justified on a re-review of the respective companies
management, growth potentials and other factors there would be without
doubt a return to reconsider the appropriate capitalization rate used to
the value the higher risk business as risk is an important factor in
determination and selection of an appropriate capitalization rate.
It is clear, therefore, that the use of a combination of valuation methods
often results in an iterative process, successive iterations more precisely
) defining the ultimate more realistic valuation.
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For a good illustration of the application of several of the foregoing
principles and considerations I invite you to review the decision of
Nurnberger v. Nurnberger, 25 Sask. R. 241. The decision is also
illustrative of the diverse values that can be arrived at by different
valuators reviewing and analyzing the same basic facts.
One, however, should express an explicit note of caution respecting the
foregoing discussion of various valuation approaches. We have to this
point discussed the various methods and factors contributing to a valuation
of an entire business or an entire company. We have not discussed as yet
the issues involved and the difficulties in apportioning the value of the
entire business among various shareholders holding different interests
(e.g. minority or majority interests in the company).
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III. MINORITY DISCOUNT/MAJORITY PREMIUMS
The subject of minority discounts and majority premiums has been indirectly
raised at numerous points in this paper. As you may recall in the
valuation portion the value we were determining was an en bloc value for a
company or business. Such en bloc value represents, depending upon the
method or approach used, a flow of earnings or a flow of funds that are
obtainable from the business.
If a single purchaser acquires 100% of such interest then of course there
is no difficulty with controlling the funds generated. However, the flow
is not easily divisible and one investor cannot easily take 20% of the
value without affecting his rights. In financial terms, when one takes a
minority interest one loses control over the decisions that are made
respecting the business generating the funds and control over when the
funds earned will be distributed to the ultimate owners. There are also
non-financial considerations associated with ownership of less than a
controlling interest including an inability to elect a board of directors
and subject to other constating documentation such as shareholders
agreements to be represented on such a board, an inability to govern
indirectly the business and affairs of the company and to exercise any real
control over the shareholders investment, a loss of ability to dictate and
control the terms and conditions on which additional share issuances will
be made or the timing of such issuances which could be effected at
inopportune or disadvantageous times from the perspective of the
) shareholder, the potential that at any time the control and direction of
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one's investment could be transferred to a third party/stranger to the
shareholder, an inability to ensure employment as an officer or employee of
the company and other factors of a similar nature all of which tend to
increase the risk associated with an investment and thus reduce its value.
The reduction in value attributable to this loss of influence and control
is called a minority discount.
The extent to which a discount is applied depends, amongst other things, on
the distribution of the other shares (e.g. is there a single majority and
controlling shareholder), the extent of the interest (for example can
special resolutions be passed without reference to the minority interest)
and legislative safeguards protecting the minority shareholder (such as
dissent provisions and jurisprudence protecting minorities).
A significant influence on the extent of the applicable discount is the
terms and conditions of any unanimous shareholders agreement or other
shareholders agreement in effect between shareholders in respect of the
corporation. Shareholders agreements can and often provide for
representation on the board of directors of a corporation thus entitling a
shareholder to access to detailed information concerning the business and
affairs of a corporation which he is otherwise not entitled. Such an
agreement can provide for some minimum dividend flows calculated as a
percentage of after tax earnings and can ensure engagement as an officer
and employee at reasonable remuneration. It can provide safeguards in
respect of the sale by other shareholders of their interest in the
)
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company as well as safeguards concerning or granting pre-emptive rights on
new share issuances.
The term majority premium is somewhat a misnomer since once you have
effected a valuation of a company one contemplates buying a majority
interest in, one does not pay a premium over the ratable portion of such
value. Instead the interest is not subject to a discount as a result of
a lack of control. Premiums paid over stock exchange prices in a takeover
situation do not truly reflect a majority premium but rather reflect the
degree to which a minority discount has been previously applied by persons
acquiring and trading in minority interests. Generally listed stock
exchange prices reflect the prior application of minority discounts.
As indicated in the introductory comments to this paper one would submit
that whenever a minority holding is held by a shareholder in a corporation
the determination of fair market value necessarily includes the application
to the rateable portion of the en bloc value of that corporation of a
minority discount. Such a discount can be very material to the ultimately
determined fair market value and discounts of 30% on common shareholdings
are not unheard of. The degree to which a minority discount is applicable
will be significantly influenced by the constating documents of the company
including the terms and conditions of any existing shareholders agreements.
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IV. ISSUES RELATING TO TAXATION
Our courts have addressed on a somewhat adhoc basis the issue of taxes
associated with assets subject of valuation. The Court of Appeal decision
in Carlson, supra, which has been favourably referred to in this context in
both the Seaberly and Shockey decisions, is the best reflection of the
current jurisprudence on the issue.
In Carlson it was the view of the Court of Appeal that the court is
required to have due regard to any tax liability that may be incurred by a
spouse as a result of a transfer or sale of matrimonial property. However
the court was of the opinion that they were not inclined to reduce the
value of the assets by the full amount of the potential and contingent tax
liability. It was their view that no present intention to sell the assets
in the near future was present and that one should be able to arrange one's
affairs to minimize or defer any taxation impact by taking full advantage
of relevant provisions of the Income Tax Act (Canada). In light of these
two factors the potential tax was discounted by slightly less than 50%.
This discount of 50% appears to have had some considerable appeal as a 50%
discount was applied to the potential tax liability in Seaberly and a
somewhat greater discount was applied in the Shockey decision.
One would submit however that the relevance of the associated potential tax
liability depends to a large extent ultimately upon the method of valuation
adopted in respect of matrimonial property.
)
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If an asset was valued at its liquidation value (which would primarily be
the result of such value exceeding its revenue producing capacity) then
such valuation intrinsically requires that associated tax liability be
fully accounted for. The only way that a holder of such asset can in
effect realize the greater value being the liquidation value is to dispose
of the asset. Until such disposition occurs the owner lives with the
effect of a lower going concern valuation.
On the other hand an investment approach valuation has already taken into
account taxation considerations in that it has calculated an appropriate
rate of return based upon after tax earnings or cash flows. In such a case
it would appear appropriate to discount to a present value a future tax
liability on disposition. Since the timing of such a future disposition is
purely conjectural a discount of approximately 50% would not appear
unreasonable.
Lastly I think it is safe to say that in light of Tax Reform 87 (in all
likelihood a misdescriptive title) future opportunities whether by a shrewd
businessman or other persons to arrange one's affairs to minimize or defer
the impact of taxation have been severely curtailed, a trend which is not
likely to reverse itself in the near future.
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V. SUMMARY
In this paper we have attempted to provide a review of some of the major
valuation methods or approaches used in valuing businesses and
corporations. Even from this cursory review it is obvious that the
valuation process can be very complex and inherently possesses a
significant degree of subjectivity. A prime example of this is the
Nurnberger decision previously referred to.
One can anticipate that practitioners will be increasingly called upon both
to dispute and to defend quite diverse valuations prepared by other
professionals. To do so ably will require a reasonable understanding and
appreciation of the concepts dealt with in the foregoing paper.
Thankfully the writer has not been required as a result of the subject
matter of other papers which are to be presented at this seminar to deal
with several important but difficult issues which include in particular the
valuation of goodwill in a context of a professional practise and
professional licenses and degrees as matrimonial property which has been
recently considered in the Ontario decision of Caratun v. Caratun, (1987) 9
R.F.L. (3d) 337.